Unformatted text preview: 8. Definitions of Foreign
There are three forms of currency risk: transaction exposure, translation exposure and economic exposure. Dr. Yinghong Chen Skövde University
Dr. Yinghong Chen Sk 1 Foreign Exchange risk Foreign exchange risk concerns risks created by changes in foreign currency levels Exposure arises because currency movements may alter home currency values of an foreign subsidiary’s accounts: balance sheet and income statements. 2
Dr. Yinghong Chen Skövde University The definitions of the three
exposures Transaction exposure arises because a payable or
receivable is denominated in a foreign currency.
receivable Translation exposure (accounting exposure) arises
when consolidating foreign-currency-denominated
assets, liabilities and profits. Economic exposure arises because the present value
of a stream of expected future operating cash flows
denominated in the home currency or in a foreign
currency may vary because of changed exchange
The law of consolidation of all subsidiaries applies to
ownership exceeding 20%+ by parent company
Dr. Yinghong Chen Skövde University Channels of Economic
Asset exposure Home currency
value of assets and
Operating exposure Firm
Dr. Yinghong Chen Skövde University Translation/accounting exposure
are not cash flow based
The magnitude of a translation exposure varies
according to the accounting convention used for
translation of foreign-denominated items.
Four basic translation methods.
The current/non-current method
The all current (closing rate) method
The monetary/non-monetary method
The temporal method.
Currently all current (closing rate) method is used by
major countries in the world.
Dr. Yinghong Chen Skövde University Translation/accounting exposure: The current/non-current method: The accounting
exposure is the net current assets
The all-current (closing rate) method: The accounting
exposure is the net assets or shareholders’ funds
The monetary/non-monetary method: The accounting
exposure is the net monetary assets
The temporal method: The accounting exposure varies
depending on the measurement method the subsidiary
is used. The items that stated at replacement cost
market value uses the closing rate method, other items
that stated at historical cost uses historical rate.
Dr. Yinghong Chen Skövde University Economic Exposure Any anticipated changes in the exchange rates would have been already discounted and reflected in the firm’s value. Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. 7
Dr. Yinghong Chen Skövde University Economic exposure PV is present value of the foreign business in home currency value.
CI is the estimated future incremental net cash inflow associated with the foreign business
CO is estimated future incremental net cash outflow associated with the foreign business
e is the expected future exchange rate
r is the appropriate discount rate n PV = ∑
t =0 (CI −CO )e
t (1 + r ) 8
Dr. Yinghong Chen Skövde University t
t t Economic exposure Ex: assuming a Swedish company has wholly owned Danish firm with a NPV 120M DKK. The exchange rate is 1,2 Skr/Dkk. And subsequently moves to 1,3 Skr/Dkk. The value of the subsidiary has moved from Skr 144M to Skr 156M 9
Dr. Yinghong Chen Skövde University Chap 9: Financial accounting and
foreign exchange According to US accounting rules, translations of foreign currency denominated profit and loss accounts are to be made at the average exchange rate during the accounting period. The UK standard allows the use of either the current rate or the average rate for this purpose. It is fair to say that opinion in the United Kingdom is moving towards the average exchange rate method. 10
Dr. Yinghong Chen Skövde University Rules of financial accounting FAS 133 and IAS 39 Transaction gains, whether realized or not, are accounted for through the profit and loss account. But there is a major exception – and this relates to a foreign currency denominated borrowing. Where a transaction profit or loss, whether realized or not, arises from taking on a foreign currency borrowing in a situation in which the borrowing can be designated as a hedge for a net investment denominated in foreign currency, then the gain or loss on the borrowing, if it is less than the net investment hedged, would be accounted for by movements in reserves rather than through the income statement. If this kind of transaction gain or loss exceeds the amount of the loss or gain respectively on the net investment hedged, then the excess gain or loss is to be reported in the profit and loss account. 11
Dr. Yinghong Chen Skövde University ...
View Full Document